Trust fund taxes are a common form of tax withholding. These are the taxes that W-2 employers withhold from their employees’ paychecks for Medicare, Social Security and income tax programs. They are otherwise known as payroll taxes. Let’s break down how they are taxed.
A financial advisor can help you optimize your financial plan to lower your tax liability.
What Are Trust Fund Taxes?
Trust fund taxes have nothing to do with private trusts or estate planning. Instead, they are the taxes which a W-2 employer withholds from each employee’s paycheck.
As the IRS’s website defines these as “income taxes, social security taxes and Medicare taxes you withhold from the wages of an employee as their employer… The income tax, employee share of social security tax and the employee share of Medicare tax that you withhold from the pay of your employees are part of their wages you pay to the Treasury instead of to your employees.”
These taxes are otherwise known as “payroll taxes” or “withholding taxes,” because they are directly withheld from an employee’s paycheck.
The term trust fund tax comes from the fact that an employer keeps these taxes in trust for the government as it collects them. It cannot use this money for any purpose or the IRS will charge it a trust fund recovery penalty. An employer withholds trust fund taxes from its employees as it pays them, typically every two weeks. It usually pays the contents of this trust to the government every three months, when it makes its estimated quarterly tax payments.
It’s important to note that there is some confusion on the meaning of this term. Some sources of authority define trust fund taxes as specifically Social Security and Medicare taxes, otherwise known as FICA (Federal Insurance Contributions Act) Taxes. Under this definition, the term trust fund tax does not apply to general income tax withholding. This is the definition embraced by significant authority such as the Legal Information Institute, however, it is not the IRS definition.
What Do Trust Fund Taxes Do?
There are many reasons why the government uses trust fund taxes.
In part, trust fund taxes exist so that businesses can add their share of the FICA payroll taxes. When you pay Social Security and Medicare taxes, you are actually only paying half of what you owe to these programs. Your employer is required to pay the remainder on your behalf.
For most employees, this means that you pay 6.2% of your income to Social Security and another 1.45% to Medicare. This tax is capped, meaning that you don’t pay these taxes on any income above the cap ($160,200 in 2023). For example, someone who earns $50,000 per year pays 7.65% of their total income in FICA taxes. Someone who earns $320,400 only pays 3.825% of their total income in FICA taxes, because they don’t pay this tax on the upper half of their earnings.
Your employer is also required to pay a tax worth 7.65% of each employee’s qualified income. They contribute their share of the FICA taxes into a trust, and pay the entire amount to the government each year.
Trust fund taxes also exist to encourage tax compliance and provide government revenue.
The United States uses what is known as a self-reporting tax system, meaning that each individual is required to calculate, file and pay their own taxes. This system has fallen out of favor in many, if not most, advanced economies given the increasing complexity of modern tax codes. Among other issues, it creates two major problems for the government. First, it encourages potential abuse by making it easier for taxpayers to avoid their obligations. Second, it creates a boom-and-bust revenue model, where the government collects much of its revenue only once per year.
As a result, employers are required to withhold income tax from each employee’s paycheck. While this system is subject to modifications, for example employees can request adjusted withholding amounts, it generally leads to much higher levels of tax compliance and allows the government to collect individual income tax revenue on a quarterly rather than an annual basis.
Trust fund taxes are not levies on private trusts. Rather they are taxes that your employer automatically withholds from each paycheck. Sometimes they are called payroll taxes. They contribute to your income tax, Social Security tax and Medicare tax obligations.
Payroll Tax Tips
- The U.S. Department of the Treasury says that payroll taxes made up approximately 30.6% of federal tax revenue in fiscal year 2022. SmartAsset’s free payroll tax calculator can help you estimate how much you will pay in taxes.
- Your employer may withhold taxes, but that doesn’t mean you can’t reduce them. A financial advisor can help you optimize your financial plan to lower your tax liability. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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